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We're All About Risk

If you invest in leaders of new industries, you're taking risks. Most of these stocks fail, just like possible Rule Breaker Metricom.

Let's face it: Rule Breaker stocks are more fun than Rule Maker stocks. Stocks of companies that are top dogs and first movers in important, emerging industries are caffeinated. Steady, solid performers like Coca-Cola(NYSE: KO) or Johnson & Johnson(NYSE: JNJ) are sleeping pills. Zzzzzzzzz...

They are more fun, but also more risky. Some of you may prefer a relaxing night's sleep to the uncertain, evolving businesses of an Amazon(Nasdaq: AMZN) or Celera Genomics(NYSE: CRA) -- and the associated stock price volatility. And even if you are like me and prefer more excitement to your investing life, recent months may have left you yearning for a little boredom. Personally, unlike the Rule Breaker Portfolio, which sold its Excite@Home(Nasdaq: ATHM) before it dipped below $5.00 a share, I've watched and held on to too many companies that have crossed the River Styx, passed Rodin's Gates of Hell, and descended through Dante-esque realms (block those metaphors!) to finally arrive in the land of penny stocks.

Yet I know that this is what happens to Rule Breakers: They can crash and burn. Notice I didn't say "can" happen. This stock or that stock may not spontaneously combust, but some certainly will, and maybe even all. While it may be true that the Rule Breaker strategy recognizes that you only need one winner, there is also no guarantee that you will get that. That's one reason we recommend devoting only a small part of your portfolio to this risky strategy -- and certainly not any money you can't afford to lose. Even then, when we have bought some of our riskiest holdings, such as eBay(Nasdaq: EBAY) or Celera, we explicitly stated that we were restricting the investment to no more than 5% of our portfolio, too.

Metricom in bankruptcyA most recent example of crashing and burning is wireless service provider Metricom(Nasdaq: MCOMQ). Metricom -- whose stock is currently frozen -- was a brilliant idea: High-speed wireless Internet service to your laptop or PDA. In a world where you could get only 9.6 kbps and then 14.4 kbps service through your cell phone or wait who knows how long for 3G or 2.5G or golly G service to bring you 64 kbps or 128 kbps or more, Metricom would offer the low 100s kbps, moving to 256 kbps and beyond, at a flat rate, with unlimited use. Companies would get it for all their employees to stay wired while on the road. Even the name -- Ricochet -- had the makings of a hot consumer brand. Sounded great. The FoolMobile even deployed its first-generation 28.8 kbps service.

Yet last month Metricom filed for protection from creditors under Chapter 11 of the Bankruptcy Code. The company ran out of money before it could light up service in enough cities to generate enough subscribers to provide the fuel for a wireless House that Cash Built. And nobody came along to save what was, to discussion board posters and shareholders like me, a "sure thing." Just like satellite wireless service provider Globalstar (OTC: GSTRF), Metricom built it (or was in the process of building it), and "they" didn't come. (A recent column examined what that means for shareholders. Basically, we're out of luck.)

Both Metricom and Globalstar had huge debt, and needed to take on more to complete their network buildouts. It didn't help that the economy soured and reduced the near-term market for their products, or that the stock market also tanked, eliminating the possibility of more funding through stock offerings that essentially rely on shareholders to be venture capitalists. But these things happen, and that's when debt may kill ya.

We don't like debt -- usuallyWhich leads me to observe that one solid characteristic of most of our holdings is that they have no or infinitesimal debt -- with the large, obvious, protuberant exceptions of Amazon, AOL once it merged with Time Warner, and Human Genome Sciences (Nasdaq: HGSI). EBay, Celera, Starbucks(Nasdaq: SBUX), and Amgen(Nasdaq: AMGN) have little or no debt. HGS has $504 million in long-term debt, but sports over three times that in cash and equivalents. And though Amazon's debt has caused many investors, such as Jeff Fischer, to question its viability, it was relatively debt-free (as was AOL) when we bought it. (Conversely, note that our one short holding, Affymetrix(Nasdaq: AFFX) does have debt -- about 11% less than its cash and equivalents -- but that's a situation where we like to see it.)

Implicit anti-debt criterionNo debt load is not an explicit criterion for Rule Breaker investing, but that doesn't mean we don't think about whether a company has or can raise enough cash to give it a fighting chance to survive until it's cash flow positive. In fact, that consideration is implicit in one of our Rule Breaker criteria -- that the stock have a relative strength of 90 or above. Think about it: If the stock is in demand enough that its performance outweighs that of 90% or more of publicly traded stocks, it has the strong possibility of using that stock as a tool for raising capital through a secondary stock or convertible debt offering.

I'm not in favor of making debt an explicit criterion. I'm not going to say that looking at a Metricom years ago, anyone could have said for sure, "With that debt, they'll never get the financing and/or subscribers numbers to survive and provide market-beating returns for investors."

In fact, when we make Rule Breaker investments, we often say that we are buying businesses whose future we can't necessarily determine, precisely because they are at the forefront of new frontiers. We are banking on visionary leadership to handle the challenges, including raising necessary capital, though we aren't going to buy a company whose debt makes it clear it's doomed (and anyway, it would likely fail some of our criteria). Most Rule Breaking investments will tank. A few will soar, and that's what the strategies are about.

In sum: Rule Breakers are more fun. But they often fall right over. We court the risk.

P.S. on shortsA last word on whether to short Research Frontiers(Nasdaq: REFR): I started a debate on shorting the company, and after much community and Rule Breaker Team discussion, Brian Lund wrapped it up with his terrific column Wednesday. According to Brian's cogent analysis of the company up against our criteria, it's not currently an appropriate short under our portfolio strategy.

The best lesson of this discussion is to have a strategy and stick to it. Ask all the questions you want, line up company after company against it, but absolutely have a strategy in the first place to give you a check on irrationality and to help you make decisions once you've determined whether to buy or short the stock.

For shorting -- whether Research Frontiers or Affymetrix or any other stock -- Wednesday's column is where the Rule Breaker Port stands. Have fun learning where you do.

Tom Jacobs' (TMF Tom9) niece interned on Capitol Hill this year and hasn't disappeared. At press time, Tom owned shares in Metricom. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.